Near-Term Dollar Outlook

The US dollar is finishing the week on a soft tone after having seen the post-QEII gains extended at the start of the week. The news stream is light. China did announce a 50 bp increase in reserve requirements and although this created a wobble in the market, the currencies quickly recovered.

The prospects of an Irish aid package continues to hang over the market like the Sword of Democles. This has helped spur the dollar's downside correction over the last couple of days after rallying for 8-9 consecutive sessions. The initial target for the euro is near $1.3770, with a break spurring another cent advance. Support is seen now in the $1.3650-70 area.

While European developments may encouraging the dollar sales, the recent behavior of the 2-year spread between US and Germany and the 3-month risk reversals are also signalling a softer dollar environment. Germany is offering 62 bp more than the US on the 2-year government obligations. This is the most since Nov 3 when the FOMC announced QEII. The market had been willing to pay a growing premium for euro puts over euro calls and it reached almost 2% in the middle of the week. Yesterday it was reduced sharply and there is follow through today. The premium is falling below its 20-day average for the first time since Oct 19.

The euro's recovery is ironically leading to an under-performance by sterling against the dollar as the euro rebounds on the cross; recovering from a 5.5% slide against sterling since last Oct. Support for cable is seen in the $1.6020-50 area. The euro's recovery against the Swiss franc allowed the dollar to test CHF1.0000 yesterday, its highest level since Sept 21. Dollar support is now seen in the CHF0.9800-20 area.

Short-term interest rate differentials between the US and Japan have also moved against the dollar-yen since mid-week. The JPY83.75 area looks to cap the greenback. A break of support near JPY83.00 could see erosion toward JPY82.40 in short order.

With one of Australia's largest mining companies announcing a A$8.4 bln investment (over 2.5 years) to expand iron ore production should ease concerns about the mining tax and blunt the impact of Chinese tightening. The Australian dollar is encountering resistance in the $0.9900-20 area. A convincing move through there brings parity back into view.